When Cerent met Cisco

<p>It's easy to look back on the telecom boom with a knowing eye, scoffing at the ridiculous run-up of tech stocks and insane valuations bestowed on days-old public companies.</p><p>Such as the $7.3 billion Cisco paid in 1999 for Petaluma startup Cerent, which had only one product and had never turned a profit. The price was questioned even in those pie-in-the-sky times, but instead of becoming a white elephant in the 2001 tech bust, Cisco is prouder than ever of its Petaluma operation and the Cerent product has proved an enduring and critical part of Cisco's optical portfolio.</p><p>"A lot of other acquisitions failed because they lost the team and the product didn't have legs," said Ajaib Bhadare, a co-founder of Cerent who shepherded the company through the Cisco purchase. "This product had legs and it was able to be sustained through the tough times."</p><p>Today, that product - the Cerent 454, which routed data communications from slow-speed copper wires onto high-speed fiber optic networks - has evolved into the Cisco ONS 15454 and is the cornerstone of Cisco's optical networking product line.</p><p>"It is absolutely clear that without the Cerent acquisition, Cisco's penetration into the carrier market would be probably half of what it is today," said Steven Levy, an analyst with Lehman Brothers. "It's been an incredibly important acquisition."</p><p>The Cerent product was unique in several ways. It was easy to use, remotely accessible and physically smaller than the equipment it could replace, a microwave-sized object swapping out three freezer-sized mainframe cabinets in a telephone company's already crowded central office.</p><p>It was the first generation of transport equipment designed around the Internet and Cerent was bucking the tide at the time by targeting phone companies as customers, which were considered hard to sell to and required year-long negotiations. And it was competing against some of the biggest telecom names: Alcatel, Fujitsu, Lucent, Nortel and Tellabs.</p><p>But for Cisco, already on an acquisition tear that would result in 18 purchases in 1999 and another 23 deals in 2000, Cerent's product would give them a product to target the optical networking market, which was very new and very hot.</p><p>The idea was that Cisco could use its data and video transmission experience to make the Cerent product better, said Gary Baldwin, a former Cerent employee who is vice president of engineering at Cisco's Petaluma office, the headquarters for the company's optical networking group.</p><p>"Overall, we're incredibly happy with how things worked out," said Craig Griffin, Cisco's director of business development who worked on the original Cerent acquisition.</p><p>"We knew it was a good deal, and given that it was at that time the largest private acquisition in absolute dollars, we were surprised by how well it was received in the industry," Griffin said. "If you roll forward to today, it is really the core of our optical technology group ... we're really happy with the traction and the momentum of the product."</p><p>After the acquisition, the product was modified to reflect Cisco's interests, such as expanding feature and hardware additions, increasing product capacity adding data services. Within two years, Cisco was shipping tens of thousands of the products to more than 500 customers. Since then, the product has undergone two major upgrades a year to keep up with changing market demands, such as adding bandwidth capacity, Ethernet capacity and multiplexing functions.</p><p>Along the way, customers for the product have changed too. Instead of just Baby Bells, Cisco now sells the ONS 15454 to independent phone companies, cable companies and even Fortune 500 companies.</p><p>"It happens to be a product line that is focused on the one segment of the optical transmission market that didn't decline anywhere near the catastrophic levels that the rest of the optical system market declined, and it is starting to grow in the last year," Levy said. "That's a reflection of Cerent's product and what Cisco has done with it since they acquired it."</p><p>Cisco has also developed new products to dovetail with the 454, Baldwin said. The Cisco 300 series is slightly smaller and can be used in an office park, while a 600 series is larger and is used in large buildings and regional offices.</p><p>"It was advantageous to us to have bigger</p><p>and smaller products that do similar but different scale functions - products that bookend the 454," Baldwin said. "It's kind of like right-sizing."</p><p>All of this illustrates the fundamental flexibility of the product, which has resulted in its ongoing success.</p><p>Not all of Cisco's acquisitions have worked out so well. The same day Cisco bought Cerent, it also bought Monterey Networks for $550 million, only to dump the technology from its portfolio two years later.</p><p>By contrast, Cerent's Petaluma offices - spread out over five buildings in a business park - have swelled from 380 employees at the time of the purchase to about 500 today - unusual in this age of downsizing. Executives there oversee work at other Cisco optical units located in San Jose, Richardson, Texas, Herndon, Va., Research Triangle Park, N.C., Monza, Italy, and Bangalore, India.</p><p>At the time, Cisco's purchase was the third largest merger in telecom history, behind Lucent's $20 billion purchase of Ascend and Nortel Networks' $9 billion deal to buy Bay Networks. Even at the time, there was some question about the valuation of the company.</p><p>"My perspective is that we did get caught</p><p>up in that excitement in that big Internet boom, which probably extrapolated our value," Bhadare said recently. "But at the same time we were a real company building a real product, with real engineers who put a lot of sweat</p><p>into it."</p><p>"What we did see was the need for the product, and that's why the value was able to be sustained," Bhadare said.</p><p>Cerent also was considering to issue a public stock offering instead of be acquired. In July 1999, it said it planned a $100 million IPO, which would have made it the second Sonoma County company after Advanced Fibre Communications to go public.</p><p>Baldwin said the acquisition offer, when it came, was welcome.</p><p>"I think for most people who were present thought, 'Hey, if you're going to be acquired, this is the way to be acquired,'" he said.</p><p>But Bhadare wonders what might have happened if Cerent had gone public.</p><p>"It's hard to say. We had an awesome team and in some ways I feel like there was potential that wasn't captured," he said.</p><p>"To Cisco's credit, they kept the majority of the team together - the engineering force together - and they've been able to see the road map that was set, with some of it being carried out," Bhadare said. "So it's actually done well. I'm impressed."</p><p>Legg Mason analyst Timm Bechter said the high valuation for Cerent back in 1999 is a moot point today, because they paid with highly inflated Cisco stock.</p><p>"The Cisco shares were never worth that much either," Bechter said. "It's like paying for something during the Civil War with Confederate money. Overall, I think you could pretty safely say that their acquisition has worked out for them."</p><p>As for where Cisco is in the optical marketplace, they trail behind Nortel, which has the best portfolio overall, but Cisco "is in there competing," according to Bechter.</p><p>"The optical business as a whole, it's a lot less than it used to be," he said. "For Cisco, it's a product they're glad they have today, but it's certainly not something that's producing double-digit growth every quarter."</p>